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3 High-Yield Dividends That Are Potentially Toxic

Just because a company pays a big dividend, doesn't mean your investment is safe

All dividend investors want higher yields, but some high-paying stocks might be too good to be true. In short, not all high dividends are healthy or sustainable. We asked three of our contributors to discuss some high-dividend stocks that could be poisonous to your portfolio. Here is what they had to say:

Dan Caplinger: Business development companies traditionally carry high yields, but they're subject to fluctuations in their payouts depending on whether they can earn enough to cover their dividend payments. TICC Capital(NASDAQ:TICC) has had a solid dividend history over the years, but a recent dividend cut could be just the beginning of a trend that could reduce its yield dramatically from its current level of around 15%.

During its most recent quarter, TICC Capital reported net investment income of just $12.8 million, or $0.21 per share. In addition, the BDC realized $7.3 million in capital losses, which roughly equates to about $0.12 per share in downward pressure on the company. When you compare the net $0.09 figure with the $0.27 per share in dividends that TICC Capital declared, you can see the potential for trouble.

Furthermore, TICC Capital suffered even larger declines in the value of its ongoing investment portfolio. All told, the company saw its net assets fall for the full 2014 year, and for the first time in several years, some of TICC Capital's dividend payments were treated as a return of capital for tax purposes.

TICC's most recent dividend payment was 7% smaller than the previous quarter's. But if the business development company doesn't start seeing conditions improve, future payout cuts could be more substantial.

Matt Frankel: Mortgage REITs pay high yields, and their business model works well in stable interest rate environments, but this can all change very easily when the cost of borrowing begins to rise.

For example, let's look at American Capital Agency(NASDAQ:AGNC), which is one of the most popular mortgage REITs in the market. The company pays an annual yield of 12.2%, but the way it achieves such a high return is risky.

The company borrows money at low short-term interest rates, and purchases mortgages that pay more. So, if a mortgage pays 4% and it costs American Capital Agency 2% to borrow the money to buy it, the 2% "spread" is its profit. In order to produce high returns, the company uses a high leverage ratio, which is currently 6.9-to-1. This means that for every dollar in assets, the company borrows almost $7. In the above example, in turn, the 2% yield theoretically becomes 14% thanks to the leverage.

However, if short-term rates spiked to say 3%, the company's mortgages would still yield the same 4%, which world narrow the spread to just 1%. As a result, even though a 1% jump in interest rates is rather small, it could easily cut a highly leveraged mortgage REIT like American Capital Agency's profits in half. A higher spike could even erase all of the profits or cause the company's cash flow to turn negative.

Of course, this is an oversimplification, but the point is that investors should be aware of the risks they take on with these high-yielding investments.

In the past, PDL Biopharma's has enjoyed a steady stream of revenue thanks to the Queen et al monoclonal antibody patents that apply to some of the best selling drugs on the planet, including the cancer drugs Avastin and Herceptin.

Thanks to its patents, PDL Biopharma was able to pocket $581 million last year, which was plenty to fuel its dividend payout. However, those patents and PDL Biopharma's licensing deals are expiring and that means that PDL Biopharma will need to reinvent itself if it's going to be able to keep returning as much money to investors as it has been.

In an attempt to blunt the risk of declining royalty revenue PDL Biopharma has invested $780 million in non-dilutive capital deals and financing agreements with clinical-stage biotech companies. That's an intriguing move, but I'm just not sure if those investments will prove profitable enough to maintain its current dividend payout and for that reason, I can't recommend this one to investors.

Author

Matt brought his love of teaching and investing to the Fool in 2012 in order to help people invest better. Matt specializes in writing about the best opportunities in bank stocks, REITs, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!
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